QUESTION 35 Illustration 25: Conversion ratio changes under inter-dependent scenarios On 1 January 2018, RHT Limited subscribes to convertible preference shares of RDT Limited. The preference shares are convertible as below: Convertible 1:1 if another strategic investor invests at an enterprise valuation (EV) of USD 100 million. Convertible 1.5:1: if another strategic investor invests at EV of USD 150 million Convertible 2:1: if another strategic investor invests at EV of USD 200 million Convertible 3:1: if no strategic investment is made within a period of 3 years Examine the nature of the financial instrument.

Solution

The financial instrument held by RHT Limited in RDT Limited is a convertible preference share. The instrument can be converted into equity shares of RDT Limited at a predetermined ratio depending on the enterprise valuation (EV) of RDT Limited at the time of a strategic investment.

The conversion ratio varies based on specific inter-dependent scenarios. Specifically, the conversion ratio depends on the enterprise valuation of RDT Limited at the time of a strategic investment by another investor. If a strategic investor invests at an EV of USD 100 million, the conversion ratio is 1:1. If a strategic investor invests at an EV of USD 150 million, the conversion ratio is 1.5:1. If a strategic investor invests at an EV of USD 200 million, the conversion ratio is 2:1. If no strategic investment is made within a period of 3 years, the conversion ratio is 3:1.

The variable conversion ratio based on specific inter-dependent scenarios is a typical feature of convertible securities. This feature is designed to provide some protection to the convertible security holder against dilution of their stake, while also giving them some upside potential if the value of the underlying equity shares increases.

It is important to note that the specific classification of the instrument as either equity or financial liability will depend on the specific terms and conditions of the instrument, including the degree of variability in the conversion ratio.

In this case, since the conversion ratio varies based on the enterprise valuation of RDT Limited at the time of a strategic investment, it is likely that the instrument will be classified as a financial liability, as the issuer, RDT Limited, may be required to issue additional equity shares to RHT Limited at a price lower than the market price, which would result in a financial liability for RDT Limited. The specific classification will depend on the specific terms and conditions of the instrument, including the degree of variability in the conversion ratio and the expected timing of the strategic investment.

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